What is Accrual basis of accounting?

According to accrual concept or accrual principle or accrual basis of accounting revenues and expenses are recorded in books of accounts when they are earned or incurred and not when they are received or paid in cash.

In essence events of business are captured in accounting system when they are actually happening and not when cash flows in or out as in many cases timings of cash flows are different from the time when transaction actually occurred. If we wait for cash, then recording might be so delayed that it is either recorded in a different period or the time until we record the transaction it will have no relevance in that period for economic decisions.

The complete contrast to accruals basis of accounting is cash basis of accounting which in fact records transactions when cash actually flows in or out. To learn more about the difference between accrual basis and cash basis accounting please read What is the difference between Cash basis and Accrual basis accounting and which one is better?

Many accounting frameworks around the world suggest using accrual basis of accounting and this concept is one of the fundamental assumptions in preparing financial statements in two of the widely used accounting frameworks i.e. US GAAPs and IFRSs. The reason is accrual basis of accounting provide more accurate view of entity’s financial position and financial performance. Because recording under this principle is not delayed. So we can safely say that accrual basis provides more accurate information regarding revenues earned and expenses incurred during the period and in addition to that what effects transactions of this period have in future. Lets understand all this with an example.

For example a credit sale was made to one customer worth 5,000 in the month of July. Customer has promised to make the payment by next month i.e. August.

If recording of 5,000 is delayed until the month of August i.e. cash is actually received then financial statements prepared for month ended July will not give an appropriate view of the business due to following reasons:

  • Sales revenue will be understated by 5,000 because entity has earned the income. Its just that cash has not reached entity against such sale. In short incomes are understated.
  • Assets of the entity will be understated  as entity has the right to receive cash of 5,000 i.e. it is receivable from customer and he is a debtor. Receivables or debtors are assets of the organisation as they owe money to it. So by not recording 5,000 as receivables users will not have any idea how many cash is to be received by the entity in the future.

If the recording is delayed until August, this information by that time will have no use as it relates to July and by August user requires information pertaining to the month of August.

Another example is of expenses like electricity bills, rentals, salary expenses etc. We record electricity expense as and when electricity is received and not when they are actually paid. Similarly rental are reported as expense when they fall due and not when actually cash is paid in this regard. Same is the case with salaries, wages, interest and other expenses.

Understanding these drawbacks of cash basis accounting, accounting frameworks require financial statements to be prepared on accrual basis as it is critical to users’ understanding and in having relevant information.

One point to remember however is that financial statements prepared under GAAPs or IFRSs are general purpose financial statements that caters general needs of users. Any specific accounting framework requiring special purpose financial statements accommodating special needs of users may require different basis for example certain industries in different countries are required to prepare accounts on cash basis.

Moreover, under given circumstances accounting framework may require to prepare financial statements on different basis. For example if entity is no more a going concern then financial statements are prepared on break-up basis which may or may not allow for accruals.

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